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Jennifer Liu - Capco

Central Clearing calls for effective collateral management

13 January 2014 | 2532 views | 0

As Central Clearing is more and more widely adopted around the globe, collateral, especially highly liquid collateral, is in high demand. Compared with bilateral transactions, central counterparties (CCPs) not only require the clearing members to post collateral
for Variation Margin (VM) but also other margins such as Initial Margin (IM) and Delivery Margin (DM) , and contribution to Default Funds (DF). The latter, in particular IM, can be substantially higher than VM, depending on the type of transactions. It is
estimated that USD $2trillion collateral will be held at CCPs.

As high quality collateral becomes scarcer in the market, it is imperative for banks to effectively manage their collateral. An effective collateral management not only helps the banks meet the collateral requirements in a timely fashion, but it can also
create opportunities to optimize their use of collateral, which can lead to benefits such as lower cost of funding, more favourable regulatory capital treatment, higher market liquidity, and so on.

To enable an effective collateral management, the following is required:

Transparency – A clear and comprehensive view of the collateral inventory in the bank. This needs to be a dynamic view that tracks the collateral movement.

Optimization tools – Tools such as powerful logarithms to allocate collaterals that meet the collateral requirements, tracks the collateral movements, and triggers substitution and rehypothecation that will allow better use of the collateral.

Efficient operational process – A streamlined process that allows the collateral pledging, substitution, and corporate action to be handled in a timely fashion.

However, to have effective collateral management is easier said than done. Below is an example that illustrates the challenges faced by the banks:

Illustration 1: Example of a Bank/dealer's collateral requirements

In this example, we assume the Bank is connected to several CCPs while keeping the bilateral trading as well . The Bank not only clears its own trades through CCPs but also acts as clearing broker to clear clients’ trades through CCP.

As illustrated, given the number of CCPs and bilateral counterparties, the different criteria for the collateral types and haircuts, different time tables, and different collateral posting processes, it will be challenging for the Bank to have a clear and
comprehensive view of collateral inventory and movement, as well as a streamlined operational process. This example only illustrated margin collateral management. Trading businesses such as Repo and Sec Lending, which involve trading based on underlying collateral,
will inevitably add to the complexity.

Given the complexities and challenges, the following areas can be explored by banks:

Organizational structure – Many banks today still have different desks manage their collateral in silos. Having a centralized and dedicated collateral management team will help manage requirements from different CCPs and counterparties,
and spot opportunities in optimizing collateral across different lines of businesses. Close collaboration between this centralized group and other functional teams in the bank, such as Front office and Back office, can help streamline the operational process
as well.

Technology Infrastructure – A well-built collateral management system can be a powerful engine that provides functionalities such as auto-allocation, auto-substitution, corporate actions tracking, and so much more. However, building a state
of art CMS system can be costly. Leveraging third-parties or vendors can be an option to address this issue.

As the banks move towards more efficient collateral management, CCPs need to keep pace with the changes. For example, some CCPs still use a very manual process in managing margins calls and collaterals, instead of an automated system and a customer friendly
interface. After all, CCPs are in place to protect the financial market from systemic risks and address the market liquidity issues in distressed market. Without carefully managing the collaterals going forward, the shortage of high quality collateral may
pose a risk to the market itself.